How is expected value used to make an investment decision between two stocks?

Conditions

• Probabilities of all outcomes sum to 1.
• Outcomes and probabilities are known for each stock.

Reasoning, step by step

1. List outcomes and probabilities for Stock A.
2. Calculate $E(A) = \sum p_i x_i$.
3. List outcomes and probabilities for Stock B.
4. Calculate $E(B) = \sum p_i x_i$.
5. Compare $E(A)$ and $E(B)$.
6. Choose the stock with the higher expected value.

Example

Stock A: $E(A) = 0.6(1000) + 0.4(-500) = 400$. Stock B: $E(B) = 0.3(2000) + 0.7(-200) = 460$. Since $460 > 400$, choose Stock B.

Common misconceptions

• Ignoring the probability weights and just averaging outcomes.
• Choosing the stock with the highest single possible payoff regardless of probability.

Watch the explanation

Explore next

• What are the key elements involved in decision analysis?
• What is the definition of decision analysis?